Suppose that the government gives a fixed subsidy of T per firm in one sector of

Question

Suppose that the government gives a fixed subsidy of T per firm in one sector of the economy to encourage firms to hire more workers. What is the effect on the equilibrium wage, total employment, and employment in the covered and uncovered sectors if we assume to start that each of the two sectors—I and II—employs workers who are equally skilled, with each sector having a labor demand curve given by w = 12 – 0.1L (where L = number of hours of labor) and with each sector initially facing a labor supply curve given by w = 0.1L. This will allow you to specify the initial equilibrium wage rates in each of the two sectors. Then assume that a government subsidy is given in the “covered sector”—I—of $2 per hour (while the other sector—II—gets no subsidy).

Explanation / Answer

Equilibrium wage in each sector can be computed by equating labor demand with the Labor Supply curve.

12 - 0.1 l = 0.1 l, Thus, l = 60 units , w = .1 * 60 = $6.

If the covered sector, gets a subsidy of $2 per hour, then the equilibrium wages in covered sector will rise to $8 even though the firm will be paying only $6 and rest is compensated by the government.

In this case both sectors employ highly skilled workers, who are in shortage as compared to unskilled or low skilled workers, this might lead to shifting of the workers from uncovered sector to covered sector and total employment might remain constant.It will increase in the covered sector but will decrease in uncovered sector, keeping overall employment constant.

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